New fund company says it can track the S&P 500, but limit losses to about 12.5% while capturing upside up to 15%.

By Gil Weinreich|March 27, 2015 at 11:52 AM

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Joseph Halpern thinks he may have built a better mousetrap through options.

Even after six consecutive years of robust stock market gains, investors remain scared and frustrated.

The fright stems from fear of the next market crash since the last one, after the failure of Lehman Brothers, was a doozy, slicing more than 38% off the S&P 500 in 2008.

And the frustration comes from not having participated in the post-Lehman market gains, either because scared investors hid their wealth in their mattresses, put it in zero-yielding cash, tried to mitigate losses through all sorts of costly or suboptimal investment schemes, got in late or never got back in.

Behavioral finance studies have long shown that investors experience the pain of loss to a far greater extent than the pleasure of gain. Investors are therefore attracted to products that offer downside protection.

But in practical experience, those strategies typically carry their own risks.

Joseph Halpern, founder and CEO of Exceed Investments, knows those risks well. The 20-year Wall Street veteran headed Lehman Brothers’ exotic derivatives commodities business, was involved in its structured products and played a role in the post-bankruptcy global bank settlements.

He thus understands better than most that a safety-seeking investor who buys a 3-year structured note knows in theory exactly what he will get when the contract is up — that is, if the guarantor is still in business.

Investors in 2008 learned that the creditworthiness of a structured note depends on the strength of the sponsor and that sometimes an issuer is unable to discharge its liabilities.

Moving up the risk spectrum away from “guaranteed” investments such as Lehman’s structured notes, investors seeking downside protection could put money in cash, but faces the obvious problem that there is no upside to cash — and indeed cash pays a rate of zero or possibly less than zero depending on how one reckons inflation.

Neither are bonds risk-free; their real return may be negative on the short end of the maturity spectrum and their risk high on the long end; what’s more, their secular bull run is getting long in the tooth, their volatility has increased and their expected return does not reach the level of equities.

Stocks, of course, offer high expected return, but suffer correspondingly high risk. And while many investors figure they can at least trim portfolio costs through low-fee index funds, it is precisely such funds that will programmatically swoon when the market crashes.

That’s where active managers come in and argue that they can offer investors greater downside protection against market falls, and indeed studies show the best managers do indeed offer this benefit. But how do you find such a manager in advance, and are the extra expenses worth the cost?

Maybe alternative investments like master limited partnerships — meant to offer some zig while a portfolio is zagging — hold the solution. But then again, investors saw that a year like 2008 offered no refuge from the carnage.

A possible in-between approach — a method of gaining the advantages of stock returns while limiting their risk — is through options, a form of insurance against losses for which investors pay a premium.

The premium of course subtracts from your return — a cost borne whether the options expire worthless or not.

A host of other potential problems best the options investor, particularly in the area of renewals, as their price rises and falls based on a range of factors including rising market volatility.

In other words, an investor needs to know what he’s doing to make it worthwhile.

Enter Halpern with his novel idea.

The veteran options trader thinks he’s figured out how to accomplish that elusive better mousetrap — a way to capture high returns, limit downside and avoid counterparty risk and manager risk.

How so?

“We’ve created an index in partnership with the Nasdaq [the Nasdaq Exceed Structured Protection Index, or Exprot] that provides S&P 500 exposure while targeting a maximum downside loss of approximately 12.5% and targets a maximum upside gain of approximately 15%.

“If you look under the chassis,” Halpern continues, “we’re … rebalancing cleared options, essentially allowing an opportunity for individuals to get into exposure for any time frame they like.”

The significance of these options is that, unlike structured notes or over-the-counter securities, the options are cleared through an exchange, which serves as a guarantor to parties to a trade that their obligations will be fulfilled.

“We’re essentially buying downside puts, which contractually obligates the buyer or seller of the put to deliver stock,” he says.

So if a company like Lehman declares bankruptcy, “in a listed environment … I have the right to sell … I don’t face off with you [the bankrupt firm]; everything goes through OCC [Options Clearing Corp.],” Halpern says.

“It really mitigates [issuer risk] dramatically; when you bought a note from Lehman Brothers, you have an IOU from Lehman. Now you’re getting 10 or 20 cents back.”

“It’s a wealth preservation vehicle that allows you upside opportunity,” he says.

What’s new is taking the ability to achieve a controlled investing experience in a mutual fund format that makes it convenient for retail clients. Exceed’s new mutual fund based on the Exprot index debuts April 14.

“Other products give you that definition, but no other product is giving it in a mutual fund; a fund itself can’t go bankrupt,” says Halpern.

“Look at fixed income annuities,” he continues. “They’re not seen in the most favorable light, but they do provide to the end user a very high level of definition.”

But if the fixed income annuity owns a structured note issued by Citibank, for example, “you have to go back to Citi if you want to get out early. With our mutual fund, you have daily liquidity and get out at [net asset value]; you can do it on a daily basis … We’re standardizing and simplifying defined outcomes with a rules-based, liquid, transparent product offering investors a much higher degree of control.”

Called the Exceed Structured Shield Index Strategy Fund (SHIEX), the fund uses SPY and SPY options to “give consumers and investors the flexibility to match their risk-reward needs with the correct exposure,” Halpern says. “You want the S&P 500, but you want a floor and a cap; that’s what we’re allowing you do.”

Aren’t there other mutual funds that use options?

Halpern says a few dozen do, but they do so as actively managed funds — in contrast to Exceed’s index fund chassis.

So, with the few funds out there making strategic use of options, “you don’t know what the outcome is. The market could be up 7% and they’re down 3% [or vice versa],” Halpern says. “So you don’t really have a good grasp on how performance is going to match an index.

“They’re taking advantage of options [to capture] pricing dislocations as opposed to taking advantage of options’ contractual nature … to get a more defined outcome. People generally … want more consistency; there’s a lot of research around aversions to risk and loss,” he says.

While options can be costly, the Exceed Fund manages them — its institutional share class is capped at 1.2% and its advisory share class has an additional 0.25% 12b-1 fee — through the way it targets exposure. Says Halpern:

“The fund does not take losses above 15%, but rather will not capture gains. The reason for this is that prior to that 15% cap we are essentially long the S&P. So at 15%, the long position simply gets called away from us — as opposed to taking a loss. In essence, what the strategy looks to achieve is paying for limiting downside by simply limiting upside. And, importantly, in a year like 2013 and 2014, the strategy should generate a very nice level of gains for a product that looks to mitigate losses.”

The Exceed CEO says his firm back-tested its method to 2001 and had its analysis substantiated by a third party, and the back-test showed the fund would have performed well in the bear markets of 2002 and 2008.

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